4 Insanely Attractive Tax Benefits of Investing in Commercial Real Estate
I’ve been saying it for years, and I’ll keep saying it for years to come: hands down, one of the best reasons to invest in commercial real estate is the incredible tax benefits.
They are what sets this asset class apart from nearly every other investment vehicle, whether it’s the stock market, the art market, or even the residential real estate market.
Here are just a few of those benefits we’ll look at in this article …
Depreciation and Write-Offs
Pass-Through Deductions
Capital Gains Advantages
Deferred Payment of Capital Gains
Long story short, it would be tough to beat commercial real estate investing in terms of tax advantages.
Note: Before we begin, let me be clear that I am not a licensed tax professional, and none of what you’ll read in this article is tax or financial advice. It is only my opinion based on my own experience. Everything in this article should be taken up with your own trusted CPA; my goal is to merely get you started with what’s possible as an investor.
OK, with that out of the way, let’s take a look at the top four insanely attractive tax benefits you can expect when investing in commercial real estate!
1. Depreciation and Write Offs
One of the many reasons commercial real estate is so profitable is the ability to take advantage of depreciation.
Commercial buildings begin depreciating the minute you acquire them. The asset may not be “physically” depreciating in terms of its usability or aesthetics, but make no mistake: every day, the building does get older and, therefore, “less valuable.”
As buildings wear out over time, the IRS allows owners of investment properties to deduct a certain amount from their income every year before tax is applied as “depreciation expense.”
Since this is an imaginary or paper expense, in that you’re not actually paying for it out of pocket, the more that you claim in depreciation, the more you can walk away with after taxes.
Essentially, you get a write-off just for owning the property!
In the context of depreciation, commercial real estate may be one of the only assets on earth that can pay you as it ages and degrades!
But what about other opportunities for write-offs...
As a property owner, one of your first and best benefits is your ability to write off the interest payments you make on your mortgage.
So, not only are you using someone else’s money to buy commercial property, but you can also write off their profit for providing you with that capital.
Other write-offs include:
Property management fees
Property insurance
Mortgage interest
Property taxes
Legal and other professional fees
Property repairs, capital improvements, and/or ongoing maintenance
Marketing expenses
And, don’t forget, these are merely the deductions you can claim just on the ownership and operation of the property.
If you decide to owner-occupy the property, meaning you actively run a company out of the premises, then you’ll find additional tax benefits.
There are an incredible number of entirely legal and ethical tax write-offs available to you as a commercial real estate investor. With the help of an excellent CPA, depreciation and write-offs can add up in very significant ways.
2. Pass-Through Deductions
A relatively quick one here, but I want to include it because:
It expires in 2025
It offers a significant deduction!
The Tax Cuts and Jobs Act created a tax deduction that can seriously benefit commercial real estate investors. It's called the Qualified Business Income (QBI - the money you collect as rent) deduction, also known as the pass-through tax deduction.
If you qualify, you can claim as much as a 20% deduction on your income through your business.
Sole Proprietors, LLCs, LLPs, or S-Corps running profitably are considered the pass-through business entities by which you may claim this deduction.
So, what can this pass-through deduction look like?
As an example, if you're part of an LLP that owns an industrial building bringing in $100,000 in rental income every year, and you qualify for the pass-through deduction, you could potentially write off up to $20,000 on your tax return.
This is obviously an excellent deduction for commercial real estate investors that's not to be missed!
Remember, these are my quick conclusions based on the Tax Cuts and Jobs Act language. There are regulations and complexities involved here, so, as with everything in this article, please consult with your CPA to determine if you qualify.
3. Capital Gains Are Taxed Differently Than Ordinary Income
Capital gains are taxable income derived from the sale of a capital asset.
What are capital gains? Investopedia defines it as such:
"The term capital gain refers to the increase in the value of a capital asset when it is sold. A capital gain occurs when you sell an asset for more than what you originally paid for it. Almost any asset you own is a capital asset, whether that's a type of investment (like a stock, bond, or real estate) or something purchased for personal use (like furniture or a boat). Capital gains are realized when you sell an asset by subtracting the original purchase price from the sale price. The Internal Revenue Service (IRS) taxes individuals on capital gains in certain circumstances."
You can determine your particular outcome by a simple formula: Capital gains are the amount equal to the sales price, less the cost of sale, adjusted basis, suspended losses, excess cost recovery, and the recapture of straight-line cost recovery.
I know, that's a lot of terms to throw at you.
You don't necessarily need to know them (leave that to your CPA). Instead, it would help to focus on the benefit the capital gains tax can bring you.
But here's the thing …
According to the IRS, as a commercial real estate investor, you're in a unique position.
The capital gains tax for you can be significantly lower than most investors' ordinary income tax. And when you sell your asset, you can even exercise a 1031 exchange (see #4 below) into another property without paying taxes at all!
Can you believe it? If you decide to sell your investment, you'll benefit from capital gains tax.
And that's the key. You do not create a "taxable capital gain event" until you decide to sell your property. If you hold for years, you're racking up what are called paper gains or paper losses along the way, but none of those gains are taxed until you sell your investment.
And even when you sell and capital gains come calling, they will likely be at a lower rate from your other taxable income, and you can even work with your CPA to legally defer paying capital gains taxes at all via a 1031 exchange …
4. Deferred Payment of Capital Gains
Is this even possible? Yes!
There are many ways the IRS affords commercial real estate investors the opportunity to defer payment of capital gains taxes.
The two most popular of these is called a 1031 Exchange and opportunity zones.
Let’s take a look at each …
1031 Exchange
A 1031 Exchange gathers its name from section 1031 of the IRS code, which says:
“No gain or loss shall be recognized on the exchange of real property held for productive use in a trade or business or for investment if such real property is exchanged solely for real property of like kind which is to be held either for productive use in a trade or business or for investment.”
To put it simply, this section allows you to avoid paying capital gains taxes when you sell a property and then reinvest the proceeds into a property of equal or greater value – if you locate and purchase the new property within a specific time frame.
Anyone who owns property held for business use or investment purposes qualifies for a 1031 exchange. Still, personal residencies and most fix-and-flips do not qualify for this type of tax deferment.
Several reasons make 1031 exchanges attractive to investors. Here are just a few of them …
Improved Cash Flow
Property and Asset Management
Estate Planning
Asset Consolidation and Division
Diversification
Buying a Vacation Home
BUT, before you get started down this road …
It’s critical to consult with your legal and financial advisors before conducting a 1031 Exchange, along with your real estate agent and all other appropriate parties that will be involved in the process.
Time is of the essence in a 1031 exchange, so it is essential to have a solid plan in place and communicate this plan to all of those you are working with before you begin to move forward.
Investors can complete a 1031 exchange on their own with a Qualified Intermediary. However, this process is very complicated and involved, so it is crucial to work with experienced people who will lead you through each step and ensure that you will execute it successfully.
Opportunity Zones
The IRS defines an Opportunity Zone as an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.
Each state has nominated certain localities within its domain, qualifying those zones as Opportunity Zones if that nomination has been certified by the Secretary of the U.S. Treasury.
Opportunity Zones were intended to be an economic development tool.
These tax benefits are designed to encourage investment in development and job creation within distressed communities.
Opportunity zone investors may defer tax on any prior gains invested in a Qualified Opportunity Fund (QOF) until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026.
If the QOF investment is held for longer than five years, there is a 10% exclusion of the deferred gain.
If held for more than seven years, the 10% becomes 15%.
Suppose the Opportunity Zone investor holds the investment in the Opportunity Fund for at least ten years. In that case, the investor is eligible for an increase in the basis of the QOF investment equal to its fair market value on the date that the QOF investment is sold or exchanged.
What does this all mean in layman’s terms?
Essentially, you could 1031 Exchange money out of stocks, bonds, or other real estate and place it into a Qualified Opportunity Fund. After ten years, your basis is reset.
No longer will you have to kick the can down the road on a 1031 Exchange and pay your taxes later.
With an Opportunity Zone, you can completely wipe your capital gains away.
So, what’s the catch here?
Opportunity Zones are intended to provide a long-term benefit. Why is that, though?
Well, for the money to be placed into a distressed community, it would have to sit there for a bit and be effective.
The government doesn’t want fly-by-night developers coming in and taking advantage of these distressed communities.
The benefits are structured so that Opportunity Zone investors truly invest within that community to make it better for everyone.
Unfortunately, only time will tell if Opportunity Zones will indeed provide investors with the returns promised by the government because it seems that every week they are changing what qualifies for an OZ, how the tax benefits work, and how much capital needs to be invested to qualify.
So, I wouldn’t recommend investing in an Opportunity Zone just to invest in one and hope for the benefits - most of the Opportunity Zone properties that I’ve seen hit the market for sale are listed at a premium, essentially defeating the entire purpose of investing in those sites.
I think the best-case scenario is if you’re purchasing a property that already makes sense, and it just so happens to be in an Opportunity Zone.
So, Should You Take Advantage of These Insanely Attractive Tax Benefits and Invest in Commercial Real Estate?
I obviously can't answer that question 👆 for you, but after nearly a decade in the commercial real estate business, I'm beyond bullish for the present and long-term future.
And I get it; to invest in commercial real estate seems like it would be a ton of work, a mountain of time, and maybe even buckets of blood, sweat, and tears.
You wouldn't be wrong about that. It is if you're doing it well.
But if these tax benefits look good to you, and you've got access to $100,000 or more that you're looking to invest in commercial real estate, I might have a way forward for you.
It may not be an "easy button," but there certainly is an easier way to invest in -- and own -- commercial real estate.
Why not let us handle this process for you?
If you want to find out how this might work (hint: it's called Syndication), we'd love to talk.
Click here to see what kind of commercial real estate deals we're up to right now!
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